Ask the tax adviser
By George Saenz • Bankrate.com

How to keep Uncle Sam from taking all your income from self-employment for taxes; and understanding like-kind exchange rules.

Incorporation could reduce self-employment taxes

Dear Tax Talk:
It seems that every book I read on how to get wealthy suggests having your own home business. My husband and I have our own business, but the self-employment taxes eat up so much of our money.

He works at a regular 40-hour-a-week job, too. Between his paycheck and our small-business income, the government ends up taking $800 a month. Our gross income is about $55,000 a year. We're raising five kids.

Are there tax breaks we don't know about that everyone else is getting?

Thanks,
Donna

Dear Donna:
Unfortunately, income and self-employment tax take up a big part of everyone's budget. In your case $9,600 a year in tax on $55,000 in income is quite high.

As a self-employed individual, you owe approximately 15 percent of your net earnings in self-employment tax. On top of this, you have to pay income tax, which could be 15 to 28 percent at your level of income.

Fortunately, with the five children, you should be getting exemption deductions and child credits ($500 per child under age 17 at the end of the year). One way to reduce the self-employment tax is to pay the minor children a salary from the home business for work they may already be performing. You can check out my advice to another reader about the tax breaks a self-employed individual gets for hiring minor children.

Another alternative to self-employment is incorporation. The net earnings from a corporation that elects to be taxed as a subchapter S corporation are not subject to self-employment tax. (A Subchapter S corporation is a corporation that has elected on Form 2553 to be taxed as such.) Instead a Subchapter S corporation pays a salary to its employee/owners.

Although salary in this case is subject to the Federal Insurance Contributions Act (FICA) tax to fund future Social Security and Medicare payments (and this is equivalent in amount to self-employment tax), not all of the net earnings are subject to FICA. Instead, FICA is paid only on the amount declared as salary. There is no set amount that has to be declared as salary.

Any excess earnings of an S Corporation can be paid to the owners as dividends, without FICA or self-employment tax. However, incorporation has its costs, including the cost of incorporating, annual maintenance fees of the corporation, the need to file another income tax return and payroll tax returns. If you want to pursue this course, I recommend consulting a local tax professional who can help you evaluate the costs and benefits of incorporating.

Tax rules on exchanging properties

Dear Tax Talk:
Can I do a 1031 exchange on a rental property and then move into the new home and use it as my primary residence?

Thanks,
RLT

Dear RLT:
The like-kind exchange rules under Internal Revenue Code Section 1031 apply to the exchange of investment or business property for investment or business property. If you exchange your rental property for another property that you intend to occupy at the time of the exchange, then you do not meet the qualifications for a tax-free exchange.

Even if you do not intend to occupy the property at the time of the exchange, but later in fact do so, the Internal Revenue Service could contend that you had the intention at the time of the exchange. Since the IRS has three years from the date that you file the return for the year of the exchange, the tax agency has the benefit of hindsight in asserting this determination.

If you want to structure this as a tax-free exchange, you have to occupy the rental as your home for two years to qualify for the exclusion on the sale of your primary residence. Alternatively, enter into the exchange with the intention of renting the new property and if you do occupy it do so only after several years.

You can read more about like-kind exchanges in our Tax Tip on this issue.

-- Posted Oct. 17, 2000

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